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Chapter 13

OTHER SPECIAL FACTORS


IN BOND ANALYSIS

Parent Company Only vs. Consolidated Return. Both bondoffering circulars and annual reports almost invariably present the earnings statement of a public-utility holding-company system in a consolidated
form, i.e., they start with the gross revenues of the operating subsidiaries
and carry the figures down through operating expenses, depreciation, fixed
charges, and preferred dividends of subsidiaries, until they arrive at the balance available for the parent companys interest charges, and finally at the
amount earned on its common stock. There is also published, largely as a
matter of form, the income account of the parent company only, which
starts with the dividends received by it from the operating subsidiaries and
therefore does not show the latters interest and preferred dividend payments to the public. The interest coverage shown by the income account
of the parent company only is an example of the prior-deductions method,
and consequently it will almost always make a better showing for the parent companys bonds than will be found in the consolidated report. The
investor should pay no attention to the parent company only figures and
insist upon a completely consolidated income account.
Example: The following example will illustrate this point:
STANDARD GAS AND ELECTRIC SYSTEM, 1931

Item
Gross revenues
Balance for xed charges
Fixed charges
Balance for parent-company stocks
Fixed charges earned

Parent company only

Consolidated results

$16,790,000
16,514,000
4,739,000
11,775,000
3.48 times

$159,070,000
57,190,000
42,226,000
14,964,000
1.36 times

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The parent company did not receive in dividends the full amount earned
by its subsidiaries, but even with this smaller income the prior-deductions
method results in a much larger indicated coverage for the parent-company
bond interest on the basis of its own results than on a consolidated basis.

Dividends on Preferred Stocks of Subsidiaries. In a holding-company system the preferred stocks of the important operating subsidiaries
are in effect senior to the parent companys bonds, since interest on the latter is met chiefly out of dividends paid on the subsidiaries common stocks.
For this reason subsidiary preferred dividends are always included in the
fixed charges of a public-utility holding-company system. In other words,
these fixed charges consist of the following items, in order of seniority:
1. Subsidiaries bond interest.
2. Subsidiaries preferred dividends.
3. Parent companys bond interest.

This statement assumes that all the subsidiary companies are of substantially the same relative importance to the system. An individual subsidiary which happens to be unprofitable may discontinue preferred
dividends and even bond interest, while at the same time the earnings of
the other subsidiaries may permit the parent company to continue its own
interest and dividend payments. In such a case, which is somewhat exceptional, the unprofitable subsidiarys charges are not really senior to the parent companys securities. This point is discussed at the end of Chap. 17
(see sixth edition text).
The fixed charges should also properly include any annual rentals paid
for leased property which are equivalent to bond interest or guaranteed
dividends. In the majority of holding-company reports this practice is
followed (e.g., Public Service Corporation of New Jersey).
The holder of preferred shares of an important operating subsidiary
has to all intents and purposes a claim which is as fixed and enforceable
on the systems earnings as have the owners of the parent companys
bonds. But if the parent company becomes insolvent, then the owners of
the underlying preferred issues no longer occupy the strategic position
of bondholder, since they cannot compel the operating subsidiary to continue paying its preferred dividends.
Example: New York Water Service Corporation Preferred may be cited
as an example. The company is an operating subsidiary of Federal Water
Service Corporation, which in turn was a subsidiary of Tri-Utilities

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Corporation. Dividends on this issue and on Federal Water Service


Preferred ranked as fixed charges of the Tri-Utilities system. When the
latter company was unable to meet interest on its debentures and went
into receivership in August, 1931, dividends on these underlying preferred issues were promptly discontinued, although both were apparently
earned and the income of New York Water Service Corporation actually
showed an increase over the previous year.

Minority Interest in Common Stock of Subsidiaries. The earnings applicable to minority stock are usually deducted in the income statement after the parent companys bond interest, and hence the former item
does not reduce the margin of safety as generally computed. We prefer to
subtract the minority interest before calculating the interest coverage. Exact
treatment would require a prorating of deductions, but this involves needlessly burdensome calculations. When the minority interest is small, as is
true in most cases, the difference between the various methods is inconsequential. When the minority interest is fairly large, analysis will show
that the customary procedure gives a margin of safety somewhat higher
than is strictly accurate, whereas our method errs moderately in the opposite direction, and hence should be preferred by conservative investors.1
Capitalization of Fixed Charges, for Railroads and Utilities.
In the previous chapter we pointed out certain difficulties in the way of
arriving at a fair statement of the ratio of stock to debt in the case of railroads and public utilities. Debt may be represented not only by bond
issues but also by guaranteed stocks, annual rental obligations, and effectively also by nonguaranteed preferred stocks of operating subsidiaries.
In computing the interest coverage these items are taken care of by using
the omnibus figure of fixed charges, instead of merely the bond interest.
The principal amount of all these obligations is usually stated quite clearly
in the consolidated balance sheet of a public-utility enterprise; but this
may not be true in the case of a railroad company, chiefly because its
rental obligations are not likely to be reflected in the balance sheet.
We suggest, therefore, that the true or effective debt of a railroad
may be calculated by multiplying the fixed charges by an appropriate
figure, say 22. This is equivalent to capitalizing the fixed charges at an
assumed rate of 41/2%in other words, to assuming that the true debt is
1 See Appendix, Note 27, p. 759, for a calculation under the three methods applied to the
report of United Light and Railways Company for 1938.

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that figure, 41/2% on which will produce the annual fixed charges. (The
41/2% figure reflects the actual current interest rate carried by railroad
indebtedness as a whole in 1938.)2
Technique Illustrated. We have suggested that the earnings coverage
for railroads be applied to either the Net Deductions or the Fixed Charges
(as previously defined), whichever are larger. In the same way the larger
of these two items should be used as the base for computing the principal amount of the roads effective debt. The technique to be followed is
illustrated herewith:
Examples:
New York, New Haven and Hartford Railroad
A. Net deductions (1932) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 18,511,000
B. Fixed charges (1932). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17,403,000
Net deductions capitalized at 41/2% . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $408,000,000
(Funded debt shown on balance sheet$258,000,000)
Preferred stock: 490,000 sh. @ 50 (July 1933). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 24,500,000
Common stock: 1,570,000 sh. @ 22 (July 1933) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 34,500,000
Total market value of stock issues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 59,000,000
Stock-to-bond ratio1 to 69
Net deductions earned, 1932 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0.93 times
Net deductions earned, 7-yr. average. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1.57 times
Chesapeake and Ohio Railway
A. Net deductions (1932) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 9,870,000
B. Fixed charges (1932). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,760,000
Fixed charges, capitalized at 41/2% . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $239,000,000
Bonded debt shown on balance sheet . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 222,000,000
Common stock: 7,650,000 sh. @ 38 (July 1933) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 291,000,000
Stock-to-bond ratio1 to .82 (i.e., $1 of stock to 82 cents of bonds)
Fixed charges earned, 1932. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3.21 times
Fixed charges earned, 7-yr. average . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3.80 times

Conclusions Based on Foregoing. The effective debt of the New


Haven was computed from the net deductions (which are larger than the
fixed charges, because they include a substantial debit for equipment
rentals, etc.). This effective debt is considerably more than that shown in

In the few instances in which a public utility shows rental payments not reflected in the balance sheet, it would be sufficient to capitalize such a rental at, say 41/2% and add this value to
the senior security total.

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the balance sheet. With the preferred and common stocks together selling in July 1933 for less than a sixth of the true debt, it is evident that the
bonds had an insufficient stock equity at the time. If the prospects were
considered favorable there might be good reason to buy the common
stock for larger capital appreciation. But no such possibility attached to
the 6% bonds selling at 92, and consequently the purchase of this issue
could not be supported by sound analysis.
The Chesapeake and Ohio exhibit, on the other hand, supplies a
stock-value ratio which fully confirms the satisfactory showing of the
earnings coverage. If the investor were satisfied with the prospects of this
road, he would then be justified in buying its bonds (e.g., the Refunding
and Improvement 41/2s selling at 921/2) since these meet both quantitative tests in satisfactory fashion.

THE WORKING-CAPITAL FACTOR IN THE


ANALYSIS OF INDUSTRIAL BONDS
For reasons already explained, a companys statement of its fixed assets
will not ordinarily carry much weight in determining the soundness of
its bonds. But the current-asset position has an important bearing upon
the financial strength of nearly all industrial enterprises, and consequently the intending bond purchaser should give it close attention. It is
true that industrial bonds which meet the stringent tests already prescribed will in nearly every instance be found to make a satisfactory
working-capital exhibit as well, but a separate check is nevertheless desirable in order to guard against the exceptional case.
Current assets (termed also liquid, quick, or working assets)
include cash, marketable securities, receivables, and merchandise inventory.3 These items are either directly equivalent to cash, or are expected
to be turned into cash, through sale or collection, in the ordinary course
of business. To conduct its operations effectively, an industrial enterprise
must possess a substantial excess of current assets over current liabilities,
the latter being all debts payable within a short term. This excess is called
the working capital, or the net current assets.
3 Some authorities exclude inventories from quick assets, but include them in current
assets. This distinction is useful, and we suggest that it be adopted as standard. It has been
followed in the S.E.C.-W.P.A. Census of American Listed Corporations, a series of studies
published in 19381940.

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Three Requisites with Respect to Working Capital. In examining the current-asset situation, an industrial bond buyer should satisfy
himself on three counts, viz.:
1. That the cash holdings are ample.
2. That the ratio of current assets to current liabilities is a strong one.
3. That the working capital bears a suitable proportion to the funded debt.

It is not feasible to fix definite minimum requirements for any one of


these three factors, especially since the normal working-capital situation
varies widely with different types of enterprise. It is generally held that
current assets should be at least double the current liabilities, and a
smaller ratio would undoubtedly call for further investigation. We suggest an additional standard requirement for the ordinary industrial company, viz., that the working capital be at least equal to the amount of the
bonded debt. This is admittedly an arbitrary criterion, and in some cases
it may prove unduly severe. But it is interesting to note that in the case of
every one of the industrial issues which maintained their investment rank
marketwise throughout 1932, as listed on page 160n in sixth edition text,
the working capital exceeded the total of bonds.4
In contrast with the emphasis laid upon the current-asset position of
industrial concerns, relatively little attention has been paid to the working
capital shown by railroads, and none at all to that of public utilities. The
reason for this is twofold. Neither railways nor utilities have the problem
of financing the production and carrying of merchandise stocks or of
extending large credits to customers. Furthermore, these companies have
been accustomed to raising new capital periodically for expansion purposes, in the course of which they readily replenish their cash account if
depleted. Because new financing is easily obtainable by prosperous companies of this type, even an excess of current liabilities over quick assets
has not been considered a serious matter. Recent experience indicates the
desirability of substantial cash holdings by a railroad to meet emergency
developments, and the bond buyer might do well to favor those public utilities also which maintain a comfortable working-capital position.
4 General Baking reached this position during 1932. Including General Baking, 13 of the 18
companies showed cash assets alone exceeding their funded debt. Certain types of industrialse.g., baking, ice and restaurant concernsnormally require a relatively small amount of
working capital in relation to total assets and business. For such businesses, the 100% net
current-asset coverage requirement for bonds would be overstringent. See our later discussion of indenture provisions requiring maintenance of working capital as a protection for
bond issues (Chap. 19 in sixth edition text).